BIOGRAPHY OF THE DOLLAR (2008) How the Mighty Buck Conquered the World and Why Its Under

Siege Craig Karmin IntroductionThe dollars universal acceptance has been an essential force behind the worlds powerful economic expansion. The flipside is a cause for concern: Enduring demand for the dollar has also encouraged the United States to run up enormous foreign debts and record trade deficits. The USD has become the primary unit of international trade and finance. China pegs its currency to it to ensure stability. All major commodities, from oil to soybeans, are priced in dollars. The Euro, introduced in 1999: 13 European nations, 317 million people. The Chinese yuan. Central banks are diversifying their reserves to include more euros: the rise of a viable alternative currency suggests central banks will store a portion of their reserves in euros on a permanent basis. Washington: cut deficits and encourage private savings. America faces no foreign exchange costs when buying commodities as long as they are priced in dollars. Its businesses face little currency risk abroad because most of their transactions are also conducted in dollars. The world benefits from the use of one main currency because cross-border investment and trade costs fall when participants dont have to convert currencies repeatedly. Important: prod the United States to be fiscally responsible so that the currency wont succumb to panic. Venenzuelan President Hugo Chavez urged his fellow OPEC members to dump the dollar and price oil in euros instead. There is a clear benefit of easy communication when were all on the same system, whatever that system may be. Until others switch to a new and improved one, it wont do any of us much good to switch on our own. The U.S. government would [should] take extraordinary measures to prevent the sort of crisis that could dislodge the currency from its central role. Other governments, fearing a collapse in the value of their own considerable dollar holdings, would have strong incentive to cooperate. (The dollar) needs to come to grips with a reduced global role in the future. [Really?! I disagree.] Ch. 1Fishing in the Three-Trillion Dollar Pond. Ch. 2Blowing Up the Money Factory. Ch. 3More Sound Than the Pound, and Good as Gold. (p. 101) 1971, Camp David: the New Economic Policy. (Economic historian and author Daniel Yergin) Sunday, August 15, 1971, 37th President Richard Nixon announced (on all three networks) that the dollar was abandoning the gold standard. Paul Volcker, at the time, undersecretary for international monetary affairs at the Treasury Department, was a key player: We were running out of gold. There was a threat of a run on the dollar. Eventually there would be a crisis. Volcker: Chairman of Fed Reserve 1979-1987. (Succeded by A. Greenspan.) Directly responsible for the dollars ascendancy in the final decades of the 20th century. Bretton

Woods agreement: the U.S. currency was pegged to gold and all other major currencies to the dollar. All dollars held by foreign banks could be swapped for American supply of the precious metal at the central banks request. By 1971, foreign countries held three times as much dollars as the United States government had in gold; USG was in no position to honor every request to trade dollars for goldor many requests should they all come at once. Liberated the dollar. [K. Philips also discusses BW, and the Nixon Administrations agreement with OPEC that all international transactions of oil be denominated in dollars.] Many economists and politicians saw the end of gold convertability principally as a sgin of American weakness. Dollars needed to be printed and valued seperatly from gold. The worlds eagerness to hold U.S. currency regardless. International currency: a currency that is regularly accepted as a form of payment beyond its own borders. The International Monetary Fund, in 2006, indicated the benefits of an international money. The widespread use of a single currency cuts foreign exchange transaction costs and boosts international trade and investment. A global currency serves three basic roles for the world economy: as a medium of exchange for people and companies in different countries to agree on a price in a currency that is acceptable to both parties; as a store of value, or a way to hold savings without fear of a severe loss in value over time; as a unit of account, or as a means for measuring the worth of an object or a service. (British philosopher John Stuart Mill in Principles of Political Economy: with some of their applications to social philosophy, 1848, wrote, Let us all suppose that all countries had the same currency, as in the progress of political improvement they one day will have. British government at the time developed the use of steam power which, allowed for the rapid production of a paper currency that was difficult to counterfeit. This in turn allowed for central banks, by now more comfortable, to hold interestbearing claims on foreign currencies, rather than just gold. Until 1871, the pound was the only major currency with an unconditional guarantee of convertability to gold.) Criteria for a nations currency used as an international currency: the nation must have one currency, and one currency only, that is used for all its domestic transactions; and it needs a central bank to serve as a lender of last resort that would support the currency and give confidence to foreign banks that used it. 1863 to 1865: the National Banking Acts, established a single currency. (America had no central bank.) Regress: Alexander Hamilton, George Washingtons secretary of the Treasury, recognized that financial stability was paramount for the Countrys survival. Federal Bank history. The Acts gave the federal governmentas opposed to the individual state governmentsregulatory control over the nations banks and created a new market for Treasury bonds, since Washington required all banks to secure their currency issuance with U.S. government debt securities. (Funded the Unions war effort, and cleaned up Americas banking mess.) Federal deposit insurance came into existence in 1933. The Federal Reserve Act of 1913 (Aldrich Plan), Nelson W. Aldrich of Rhode Island.

For Washington, a global financial system fueled by the dollar would bring lower government borrowing costs through the ability to sell Treasury bonds at lower rates. Corporate America would be able to aquire foreign companies at marked-down prices. For American citizens, the global use of the dollar would mean cheaper financing on everything (cheaper travel costs abroad). Federal Reserve as lender of last resort: giving foreigners confidence that when exporting or importing products in dollars, there was an institution to back up these transactions on behalf of American commercial banks. 1944, Bretton Woods, New Hampshire. 730 delagates, 44 countries. Aimed to create a system that would allow investment capital to flow easily across borders. U.S. Treasury/J. M. Keynes. Greenback fixed to gold at $35 an ounce, and all other currencies would be arranged at fixed rates to the dollar. International Monetary Fund (IMF) was created, and decided when and if a country could change its fixed rate against the dollar. The Soviet Union did not sign the agreement. 1960s and 70s: an increasing amount of international trade relied on the U.S. currency; most countries used the dollar as the primary currency when doing business with each other. Two potential contraints of postwar monetary system: First, the USG guaranteed that central banks could, at any time, cash in all of their dollars for gold. It was only a matter of time before the gold scarcity would result and precipitate a crisis. This meant mismatch between foreign reserve dollar holdings and Americas ability to exchange it for gold. But so long as foreigners would hold dollars instead of gold, things were good. Greenbacks had lower transaction costs than gold and earned them interest, so the incentive to hoard was lucrative. USG incentive to pay interest contributed to the economic reconstruction of its Cold War allies. 1948-1954, Marshall Plan gave Western European countries $17 bilion; counteract Soviet influence. Deficit in balance of trade payments resulted. Bring into doubt Americas ability to exchange all those greenbacks for gold. European banks would demand gold for its dollars. USG would be unable to honor all requests simultaneously. 1958-1961, USG lost $5.4 billion in gold. President Kennedy instructed Treasury to intervene and stabilize the dollar, and he pushed a change in the tax system meant to encourage exports and cut the deficit. Efforts paid off. LBJs second term: funding for escalating a war in Vietnam, footing the bill for a large military presence in W. Germany, committing billions to Great Society program (a variety of new policies from student aid and low income housing loans to Medicare and Medicaid). Washington was forced to print more dollars to pay for the accelerating costs of the Vietnam War, this led to greater inflation, and the U.S. ability to convert dollars to gold became increasingly strained. Nixons treasury secretary, John B. Connally; he would pressure foreign heads of state to adjust their currencies against the dollar. 1970: Americas gold coverage slipped to 22% of dollars held in central banks abroad, down from recent levels of 50%. August 1971, House Subcommittee on International Exchange and Payments, concluded dollar is overvalued; change the exchange rate system. Nixon agreed. Smithsonian Agreement. The dollar would be backed by something much more fragile and abstract but, at the same time, more liberatingpeoples faith in the USGs ability and willingness to honor all dollars. It

could print more dollars, and borrow more dollars through the Treasury bond market. Support of the dollar is the sale of U.S. Treasury bonds to foreign countries. Regarded as the worlds safest investment because they are guaranteed by the USG. Central banks stash reserves in these securities and private investors hold them as risk-free investments that are highly liquid, or easy to buy or sell in large quantities. In 1973 the Organization of Petroleum Exporting Countries (OPEC) announced and oil boycott. The OPEC price escalation was a direct response to Nixons decision. Oil traded world-wide in dollars and if the USG was going to permit a free fall in value, that meant oil-producing nations would receive less and less real value for the commodity. Barrels of crude oil are sold in dollars: when the dollar weakens OPEC feels a direct hit. Attempt to compensate for their reduced purchasing power. Oil prices tend to rise when the dollar falls and often ease when the dollars value is rising. Multilateral trade negotiations under the General Agreement on Tariffs and Trade (evolved into World Trade Organization). Wall Street further developed futures and forward markets, derivative products that allowed companies to lock in a set price for commodities a year or more ahead of time. Ch. 4The Trimphs and Travails of a Dollar Colony. Ch. 5The Dollars Buyers of Last Resort (p.197) South Korea has usurped some of Americas financial independence by accumulating massive dollar reserves (along with China and Japan). Their dollar war chest has made its central banks every move closely watched by currency and government bond traders. Any sign that these countries are losing their appetite for dollars is considered potentially disastrous for the US currency. To insulate its economy against financial shock, they rapidly built up their foreign currency reserves. If South Korea sold dollars, sparking a broader sell-off in the currency, it would reduce the value of its own holdings and potentially destabilize its own economy. A modern development in the US economy is the sway that foreign technocrats hold; if the dollar bestows many unique advantages, it can also bring unintended consequences. Central bank reserve diversification: central banks hold foreign currency reserves for the same reason people keep fire extinguishers in their homes or spare tires in their cars: they want it there in case of an emergency, even if they hope theyll never need to use it. Theres no clear consensus about the appropriate level of foreign reserves though economists think the minimum should exceed a countrys short-term-foreign-currency debt. The Asian Tigers (Thailand, Malaysia, the Philippines, Indonesia, Singapore, and South Korea) grew their economies by 8 to 12 percent between the mid-1980s and early 1990s. The model was cheap labor and mass exports to the West. Much profit was funneled back into education and improving worker productivity. Public and private sectors worked in harmony. Asias stock markets boomed due to relatively high interest rates that attracted huge amounts of foreign capital and investors who were eager to finance and profit. 1997: US interest rates rise

and force Asian countries to hike up their own already-high interest rates to continue to attract foreign capital. Foreign currency debt levels rose and current account deficits ballooned. These deficits caught the attention of currency speculators. Most Asian countries maintained monetary stability by allowing their currencies to trade only within a narrow range against the USD. Now their currencies appeared vulnerable when the foreign reserves they needed to defend looked dangerously low. Asian stock and bond markets plunged as governments across the region were forced to devalue their currencies. The overnight bank rateand overnight lending ratethe short-term rates at which banks lend to one anothersoared to ward off speculators. Companies that borrowed heavily in dollars found that debt much harder to pay back; bond ratings were cut from investment-grade to junk, further raising the cost of borrowing dollars. The Organization of Economic Cooperation and Development (SK and Japan are the only Asian countries that belong to) this elite club of democratic, free market nations. SK had too much dollar debt that was due in the near-term and not enough in foreign reserves to convince creditors that it could make good on all those loans. Foreign currency reserves went down to $5 billion from $30 billion. The common lesson was for these countries to boost their reserves. By 2007, Asian central banks boasted foreign currency reserves of more than $3 trillionmore than double the amount held worldwide in 1995 (2/3 of the total was held by Japan and China). SK steadily accumulated dollars since succumbing to an IMF bailout. Their reserves ballooned to $110 billion by 2002, and by 2006, that figure had more than doubled. Today (2008) the Bank of Korea boasts more than $250 billion in foreign currency holdings, most of them in dollars; 5th highest reserve total in the worldtrailing only China, Japan, Russia, and Taiwan. SK economy focuses on sales abroad, particularly in the US where it competes against China. Since China keeps the yuan pegged to the dollar at what most analysts consider and undervalued level, the BoK felt it had to keep the won cheaper versus the dollar for SK to be competitive. SK officials would intervene in the FX markets buying dollars and selling won; the more exports to the US, the more dollars the SK government adds to its growing stockpile. Some members of Congress have been critical of China for keeping its currency from appreciating versus the dollar. As long as Asian governments keep their currencies weak, it means American consumers can buy goods made in Asia at discounted prices. This keep US inflation subdued. Moreover, Asian governments plow most of the dollars they acquire from exports to the US back into the US Treasury market; their regular and robust purchases of government debt have kept bond yields near historically low levels. That means that the government can borrow cheaply, but these low yields translate into low-interest-rate loans for the consumer on cars and home mortgages. February 22, 2005: SK decided to diversify its FX reserve holdings (dump dollars in favor of other currencies, like the euro or yen). Other Asian countries followed suit. As US trade deficits and the countrys debt relative to gross domestic product grows, foreigners become wary of holding more and more dollars. The price of crude oil and gold, both of which tend to move in the opposite direction of the dollar, surged. The surge in oil prices also elevated reserve

holdings in Russia and the Middle East. The cumulative effect is that central banks (especially Asian central banks) have become the last line of defense for the dollar. They are the buyers of last resort. Countries still hoard US government bonds because they are still considered the safest and most easily tradable securities around. Asian central banks may remain content to buy dollars as long as those countries continue to rely on exports to the US as a main growth engine for their economies. Yet, Americas growing current account deficit (the difference between what the US earns abroad and what it spends abroad) has raised concerns among economists and currency analysts. <Current US account deficit: RESEARCH.> The US is the worlds largest debtor nation. Unlike developing countries, the US borrows abroad in its own currency, so its creditors dont have to worry if the US has enough dollars to repay the loans. Some foreign bank officials have expressed concern that US imbalances could cause a run on the dollarand those with the most dollars will feel the pain most acutely. In China, which as an estimated $405 billion in US Treasury debt as of mid-2007 <TODAYS FIGURE> has raised the prospect of Beijing diversifying into other currencies. Russias finance officials have also had harsh words against the greenback: in 2006 Russia announced it held 50% of its reserves in currencies other than the dollar. Middle Eastern nations, flush with petrodollars from rising oil prices, are becoming more skittish about the weakening greenback as they try to prevent their economies from overheating. Kuwait announced in May 2007 that it was ending its currencys peg to the dollar to fight inflation. Asian central banks like Taiwan, Singapore to China and Japan worry about the deteriorating value of their own massive dollar reserves and would not want to be the last ones to sell. Bridgewater said that if central banks were to suddenly stop accumulating dollars and investing in US government debt, the fallout for the American economy and interest rates would be severe: US bond yields would have to rise about 1.5 percentage points to attract private investor money to offset the lost central bank purchases. Sommers, Treasury Secretary for the Clinton Administration expressed concerns about the US reliance on Asian central banks to loan us money (which is what buying our government debt means). Foreign nations, particularly Asian central banks are actively accumulating claims on the US by gobbling up US Treasury billsthe countrys dependence on foreign cash is distressing. Ch. SixAn End to Americas Exorbitant Privilege? (p. 225) The dollar is a victim of its ownand Americassuccess. Global demand for dollars leads us to print more, global confidence in the US leads foreigners to snap up more Treasury bonds, and a strong economy that is open to the rest of the world leads American consumers to buy many foreign products. The result is growing indebtedness to foreigners, which means an ever-rising percentage of American GDP has to go toward financing interest payments owed to foreign lenders.

There are many reasons to believe that the euro may never seriously rival the US currency for the top spot. It faces obstacles all its own. First, its not even clear that Europeans want to spread the use do the euro throughout the world. Germany and France (the driving forces behind the EU and euro) have historically held opposing views on the benefits of a currencys use abroad. Germans tended to frown on a global role for the Deutsche mark because they felt it would complicate the ability to manage their own currency. France sees a widely used currency as a means of exerting global influence. To many critics, the problem lies with the ECB, which sets interest rates for all thirteen member states. Countries may try to flee the EMU. Once out of the eurozone, a nation would face a sharp rise in interest rates on its public debt that could lead to higher taxes, a recession, and other unforeseen problems. The Chinese yuan focuses on economic size and strength. Many think the yuan will become the global standard when China inevitably becomes the worlds economic heavyweight and largest trading nation. Such a transition is still purely speculative. It would require Chinas capital markets to mature and open up to foreign investment as the US and European markets have done. Most governments when pressed to raise money for domestic programs face a dilemma: raise taxes, cut back on those programs, or cut other programs. Countries can also borrow money as a way to avoid that choice. But at best its usually a temporary problem. The US hasnt faced this problem: Asian economies have kept their currencies cheap, making their goods inexpensive and boosting their sales to the US. American consumers have responded by buying Asian products. In effect, Americans are sending their savings abroad. This creates a surplus of dollars in Asia that central banks there invest back into the US through purchases of Treasury and other US bonds. The cycle starts all over again: interest rates stay down and loans are cheap so Americans can continue to borrow and spend. American companies can also borrow in the corporate bond market at cheap rates because their borrowing costs are priced off the low Treasury market yields. The overseas demand for dollars enables Washington to run large deficits. Excluding Social Security, Washington collects enough revenue to cover only about two-thirds of what it spends; the remaining comes from foreign purchases of Treasury debt. The concern is that this dynamic cannot last indefinitely. In 2005, US interest payments on foreign debt came in at $114 billion, or about $310 million per daythat equates to slightly more than $1 million for each man, woman, and child in America, every day. Government data in March 2007 put foreign debt at around 16% of GDP. A significant decline in both consumption and investment will mean a recession in the US. Recession in the US would have consequences for the world economy. Even a gradual reduction in the dollars international use could have disruptive consequences. A one-currency world has helped unleash a period of unprecedented economic growth, fueled by a boom in cross-border trade and investment. A single or dominant currency used in international reduces transaction costs of converting one currency to another and thus spurs more trade and investment.